Failing Health Care Co-ops Will Cost Taxpayers

Consumer Operated and Oriented Plan Programs (COOPs) were really a political compromise between Members of Congress who wanted a public plan option and those who didn’t. Once the Affordable Care Act passed, COOPs had outlived their usefulness. However, they are now failing and will cost taxpayers plenty. Senior Fellow Devon Herrick testified before a congressional committee.

Features of Chilean Pension Payouts

“Regulations limit workers choice of pension funds, retirement age and retirement income options.”

Chilean workers are required to contribute 10 percent of their wages (plus another 2.5 to 3 percent for administrative expenses and survivors and disability insurance) to personal pension accounts. The following text sums up the system. The accounts are managed by pension funds, known by their Spanish-language initials, AFPs. These funds must invest according to very strict guidelines. Payouts are also tightly circumscribed. Workers cannot access their funds for the purchase of a house, education or medical expenses, as they can in some other countries. For retirement, workers basically must choose between annuitization and programmed withdrawals.3 While the terms of an annuity are set on the date it is purchased, programmed withdrawal terms vary every year and retirees who start with them can switch to annuities later on. Additionally, workers must choose their age of retirement, subject to eligibility conditions described below. These are likely to be the key choices that are offered in many reforming countries. The only account-holders allowed to cash out some of their funds are those with accumulations large enough to produce a pension that is at least 120 percent of the minimum pension guarantee described below and at least 70 percent of the worker’s average wage over the past 10 years; the surplus over the amount necessary to fund this pension can be taken as a lump sum upon retirement. Few workers have met this requirement.4

“Workers are guaranteed an inflation-adjusted minimum pension that closely tracks the growth of real wages.”

The Minimum Pension Guarantee. Regardless of the option chosen, the government promises to keep the pension at or above the level of a minimum pension guarantee. This guarantee is available to all workers who have contributed to an individual account for at least 20 years. If the worker’s own accumulation is not enough to cover a minimum lifetime pension, the government provides a subsidy out of general revenues to bring it up to that level.5 An average wage worker should be able to reach the minimum level with 20 years of full time work. Therefore, those whose own pension is less than the minimum on their date of retirement have either earned less than the average wage or worked and contributed only part-time. After retirement, the minimum pension guarantee reduces the risk that workers will outlive their savings (longevity risk) or face a decline in the value of their stocks and bonds (investment risk), but it increases the risk to the public treasury, which is left with a contingent liability.6

By law, the minimum pension is indexed to prices, but in reality it has kept pace with wages as a result of political decisions. During the 1980s, real wages fell in Chile and then recovered. The guaranteed benefit also fell and recovered, both with a lag. During the 1990s real wages rose steadily; the guaranteed benefit again rose more slowly, but caught up by the end of the decade. As Figure I shows, over the entire 21-year period, 1981-2002, real wages rose 50 percent while the guaranteed benefit rose 41 percent for retirees under age 70 and 54 percent for those over age 70.7 At the beginning of the period the guaranteed benefit was about 25 percent of the average wage, and by the end about 24 percent.8

When the guaranteed benefit rises, it rises for all retirees. Thus it may ultimately apply to annuitants as well as to low income pensioners taking programmed withdrawals. In effect, the minimum pension guarantee protects workers from the risk that the socially acceptable pension floor will rise during the period of their retirement. It jumps by about 9 percent for pensioners once they reach age 70, possibly because it is thought that they will run out of their voluntary savings by that time. It is reduced for early retirees by a formula that is based on the age of retirement from the pension system. This means that the minimum pension guarantee is specific to each individual — which in the long run may make it difficult to track and enforce. It also applies to survivors and disability benefits — widows supposedly receive 60 percent of the minimum pension guarantee based on their husbands’ savings, but because of special adjustments, they actually receive 100 percent of the guarantee.

How Annuities and Programmed WithdrawalsWork. Under annuitization, workers turn their entire accumulation over to an insurance company that provides the annuity, subject to detailed rules set by the insurance regulator. The retiree forgoes future control over investments and gives up the right to leave bequests (except for that embodied in a joint annuity or a guaranteed period annuity). In exchange, the retiree gets a stable income stream that is guaranteed for life. Regulations require annuities to be fixed rate rather than variable and price-indexed for inflation. For married men, the annuities must be joint with 60 percent of the husband’s annuity paid to a surviving spouse. (The Chilean government has just changed these rules to allow variable annuities and annuities issued in foreign currencies, but the new rules have not yet been implemented). If the amount of the guaranteed minimum benefit is larger than the annuity, the government tops up the payout. Above the minimum, the government insures 75 percent of the worker’s annuity up to about US$1,000 monthly, in case the insurance company becomes insolvent.

To prevent insolvencies, the government sets stringent reserve, equity and asset-liability matching requirements. So far it has never had to pay this insurance. Subject to meeting regulatory requirements, insurance companies determine annuity payouts and bear the longevity and interest rate risk. They are not permitted to charge explicit fees or to require annuitants to cover sales commissions explicitly.

“Instead of annuities, retirees can opt to gradually withdraw their funds.”

Under programmed withdrawals workers keep their money in a managed account and the permissible withdrawal per year depends on a formula that is based on assumed mortality and interest rates that are set by law.9 Workers retain control and bequest rights over the remainder of their accumulation, subject to regulatory constraints. Their investments may lose money, and even if they don’t the pension is likely to decline dramatically through time, due to the way the formula works (discussed below). If the payout falls to the minimum pension guarantee level, payouts stay at that level until the account is used up, at which point the government pays the guaranteed amount. Like annuities, programmed withdrawals must be joint for married men (and for women with dependents). The same companies that manage investments during the accumulation stage manage them during the payout stage, subject to rules established by the regulator. Fund administrators have no control over the formula that determines payouts nor do they bear the mortality and interest rate risks. (These risks are borne by retirees and, ultimately, by the government as guarantor.) In contrast to insurance companies, fund administrators are required to make all fees explicit and all investment earnings must be passed on to pensioners.

One group of retirees does not have a choice between annuities and programmed withdrawals. Those whose accounts are not large enough to purchase an annuity at or above the minimum pension must take programmed withdrawals and spend down their savings, after which the government pays the full minimum pension each month. Pensioners can become subject to this restriction some years after retirement, hitting the floor as the programmed withdrawal payout goes down while the guaranteed minimum pension rises. As of 2003, 70 percent of all programmed withdrawal pensioners (or 24 percent of all retirees) were in this no-choice situation.

In sum, pensioners with annuities get a fixed payout, pay no fees except those implicitly embodied in this payout, and insurance companies get the varying residual; while under programmed withdrawals, account managers get a fixed explicit fee and pensioners get the varying residual. Both groups receive ultimate protection from the government safety net. Almost two-thirds of all retirees have annuitized and they constitute about three-quarters of those who had a choice at their date of retirement. [See Figure II.]10

“Most early retirees buy annuities, while later retirees make programmed withdrawals.”

Choice between Normal and Early Retirement Age. Workers must choose the age at which they will begin to withdraw their money from the system. Normal retirement age is 65 for men, 60 for women. After this age, any worker may begin withdrawing funds, regardless of how much he or she has accumulated. But starting in 1987, regulations began to facilitate earlier withdrawals by permitting early retirement once workers have an accumulation large enough to finance a pension that is 110 percent of the minimum pension guarantee and 50 percent of their own average wage. (The government has just decided to gradually change these requirements to 150 percent and 70 percent, respectively.)

“Early retirees usually do not stop working; but they do stop contributing to their accounts.”

For workers who meet these conditions, continued saving through the social security system becomes voluntary rather than mandatory. It is important to note that “early retirement from the system” does not mean “retirement from the labor force.” It only means that workers start withdrawing from, and may stop contributing to, their retirement accounts. In fact, the elimination of the required contribution of 13 percent of wages may have a positive impact on the labor supply of older workers.11 But the fact that workers can stop accumulating has a negative impact on their future pensions and the finances of the government. As Figure III shows, among current pensioners, 60 percent retired early, often before the age of 55.12

Indexing for Inflation. In Chile, both nominal (pesos) and price-indexed (UFs) currencies are in common use, and long-term financial transactions are usually quoted in the latter — a consequence of Chile’s long experience with inflation. Regulations require annuities to be issued in UFs. (In the future they may also be issued in select foreign currencies). Initial benefits are lower than they would be if they were peso-denominated, but the nominal value of UFs increases with inflation to maintain a constant purchasing power. For instance, an annuity issued in 1993 in Chilean pesos would have fallen to only 63 percent of its initial real value by 2002, and one issued in 1983 would have fallen to 5 percent of its initial real value by 2002. Price indexation avoids this problem of falling real values. It also saves the government considerable money, since annuities in nominal (current) pesos would be front-loaded — meaning they have a higher initial value, lower real value later on, and would quickly fall below a price- or wage-indexed minimum pension guarantee. Inflation-adjusted annuities, in contrast, maintain their value in real terms over time.

Monthly programmed withdrawals are also price-indexed and most of the investments backing them are price-indexed. However, programmed withdrawal payouts are recalculated every 12 months and, as discussed below, the formula yields a declining real value over the retiree’s lifetime. This increases the probability that the pension guarantee will eventually kick in.

Joint Pension Requirement. As noted, married men who annuitize must use joint annuities, with the surviving widow receiving at least 60 percent of the husband’s annuity (if there are surviving dependent children, this becomes 50 percent to the widow plus 15 percent to each child). The formula for programmed withdrawal includes these same provisions for survivors, which diminish the amount that the husband can withdraw. This requirement provides insurance for widows financed by their husbands rather than by the public treasury. In effect, husbands must put aside some of their retirement savings to cover benefits to their wives, who are likely to be younger and outlive them. If the wife is five years younger than the husband and has a life expectancy that is three years greater than his — the typical case in Chile — this reduces his monthly payout by about 17 percent. [See Table V.]13 In contrast to males, females are not permitted to purchase joint pensions, unless they have disabled husbands or dependent children.

While many husbands would have chosen the joint annuity option voluntarily, some might have purchased an individual annuity in the absence of this requirement because they place a greater value on their own consumption. The wife is allowed to keep this joint pension in addition to her own pension, if she has worked. The mandatory joint annuity or joint programmed withdrawal saves the government money since, together with the surviving wife’s own pension, it often brings her income above the minimum pension guarantee point.14

Disability and Survivors Insurance. In the early years of the new system, few people retired with old age annuities since workers approaching retirement age were likely to remain in the old defined-benefit system15 and those who switched did not have many years in which to build their accounts. Initially most payouts were for disabled and survivors (D&S) beneficiaries, since demand for these occurred almost immediately as some workers died or became disabled. The new system specified a disability benefit equal to 70 percent of the worker’s average wage (50 percent for those with partial disability), and set up a complex schedule of survivors benefits. If an individual qualified for these benefits, the money in his account was topped up sufficiently to allow him to purchase the specified annuity or programmed withdrawal pension.16

“Accounts also fund disability and survivors benefits.”

Specifically, disability and survivors insurance takes place in two stages: In the first stage the pension fund administrator purchases a group contract with an insurer of its choice to put into the account of the disabled or surviving beneficiary an amount sufficient to purchase the required annuity. The insurance company is obligated to turn this into an annuity, if desired by the individual. The cost of this group insurance, less than 1 percent of wages, is passed on to workers. In the second stage the disabled worker decides whether the payout should take the form of programmed withdrawals or an annuity, and if the latter, from which insurance company to purchase the annuity. This procedure facilitated the early growth of a competitive annuity market, before the demand for old age annuities appeared. In 1983 disability and survivors benefits constituted 98 percent of all payouts and remained more than half of the total through the 1980s. However, old age pensions, particularly early retirement pensions, were growing in relative size as workers began to retire, and by the 1990s they dominated the industry. Currently, disability and survivors benefits comprise more than one-third of all policies but less than one-quarter of all payouts. As Table IV shows, about one-third of all outstanding disability and survivors policies are individual annuities.17

Disability and survivors annuities played an especially important role in getting the insurance industry off to a rapid start. A number of countries have moved from pay-as-you-go systems in which benefits for current retirees are funded by taxes on workers to multipillar systems, in which workers’ contributions to their own retirement accounts fund a large part of their benefits. These countries have varied rules regarding whether disability and survivors benefits are paid through the public or private sector or both. Allowing them to be paid through private insurance companies is an effective way to stimulate the growth of the industry in the early years of the new system, so when the much larger demand for old age annuities appears, the capacity already exists.